Why has no one shorted FTX?

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Six months before the collapse of FTX in November triggered a cryptocurrency crisis, there was another cataclysmic event: the stablecoin Terra exploded, wiping out around $1 trillion in value and setting off a cascade of crypto business failures. Terra’s collapse came as a shock to most, but not everyone.

A hedge fund called Galois Capital was among the few to smell something rotten in Terra and took a short position betting that the price of Terras twin cryptocurrencies would fall. The gamble paid off and Galois turned a profit, earning kudos for making a smart move at a time when the rest of the crypto world thought Terra prices would go to the moon.

Galois’ decision to short Terra was the same type of counter-intuitive gamble that has been mythologized in past financial debacles. The most famous example was celebrated in the book and film The Big Short, which told the story of a handful of daring investors who foresaw the collapse of the US mortgage industry in 2008 and made big money. money by betting against it.

Now, in the wake of FTX’s catastrophic $32 billion explosion, it’s worth wondering why no one took a “big short” against a company that, in retrospect, was throwing signs before- runners ranging from shoddy accounting to no board to back a CEO who spent important meetings playing League of Legends.

“You think it’s going to end badly”

Chris Drose, the founder of Bleecker Street Research, made a name for himself shorting the stock of a struggling healthcare giant called American Addiction Centers, and has since released exhibits on everything from air taxis to a ill-fated sports hustle called Hall of Fame Village that is currently trading in penny-stock territory. Drose says he and other short sellers on Wall Street have been watching the crypto market closely for years.

[From] the point of view of someone who cares about fraud and wants to deal with fraud, you’re outside the best party in the world, and you look inside and you think things are bad end,” he observes. “But I think they know that if they let you in, it’s going to be over for them quicker.”

The story continues

This year, Drose shorted Coinbase shares, but he did not short FTX, Terra, or any other top blockchain project. Although FTX did not have publicly traded stocks, the usual currency for short sellers, it had a sufficient supply of its liquid internal token, called FTT. Anyone holding a short position on FTT in early November would have passed themselves off as a bandit. So why didn’t he short out FTT?

Drose admits he didn’t see FTX’s collapse coming, but says that even if he did, there was a lack of financial infrastructure in place for his fund to short a crypto token.

Here’s how short selling works in more traditional finance: if you’re a fund manager who wants to short Apple shares, for example, you call a top brokerage such as Goldman Sachs or JP Morgan and their ask to lend you Apple stock for a specific period of time, after which you agree to return it ideally for less after the price falls, allowing you, as a short seller, to keep the difference as a profit .

It’s different in crypto. While there are a handful of prime crypto brokers, such as Genesis, that can run short-sell bets, there are no major registered financial outlets like JP Morgan in the space and that poses a unique set of risks for anyone in the business of managing someone else’s money, says Drose.

“If I sold a stock short and came back [in] six months when I went to hedge it and my prime broker was insolvent, I would be in trouble,” he said. “Especially for a hedge fund manager who manages other people’s money, you you really have to trust your prime broker to take care of your clients’ funds.”

Drose’s apprehension seems to be well placed. Earlier this month, Genesislong considered a respected name in crypto disclosed that it was in financial trouble, leaving customers unable to withdraw their funds.

Another challenge for retail investors looking to place a crypto short is access. Major crypto brokers generally cater to large investors, which makes them inaccessible to many stock platforms unlike Fidelity or Schwab, which allow retail investors to take short positions.

Tom Dunleavy, Principal Analyst at Messari, says there is another way for retail investors to short cryptocurrencies: they can turn to a futures exchange like Binance (or until recently FTX) to arrange a trade in which a short seller takes one side of the market. trade while someone who is bullish (or “long” in financial jargon) takes the other side. But this is not a particularly convenient option because it is very expensive.

“Most short bets are placed using perpetual futures, a mechanism unique to crypto markets, due to the lack of a robust crypto options market,” Dunleavy explains. “Perpetual futures contracts allow players to go long or short, with one party paying the other a small fee for the privilege of holding the position. Bullish sentiment in the crypto market often makes bearish bets costly to store for long periods of time.”

The short seller must also pay additional fees to the exchange and there is also a risk, of course, that the futures exchange will become insolvent and gobble up your funds.

Could Short Sellers Help Avoid Future Crypto Meltdowns?

Short sellers are controversial figures in the world of finance and are unpopular with some who view them as vultures preying on struggling businesses. Others, however, believe they are doing an important service to the markets by highlighting companies that may be committing fraud or misrepresenting their financial performance and they are often right, as was the case with the protagonists of the Big Short. .

Ciamac Moallemi, professor of business analysis at Columbia Business School, believes that short sellers play an important role. “The general academic view is that short selling is net positive,” Moallemi told Fortune. “Without short selling, there is no market mechanism to draw attention to [bad actors].”

Moallemi thinks this applies to crypto markets in the same way it does to equity markets, suggesting that in the future, a larger and better-regulated short-selling infrastructure in crypto could attract investors. watch out for fraudulent companies.

While there are ways to short cryptocurrencies, Moallemi notes that there is also an additional risk for potential short sellers: losing profits if an entire exchange crashes, like with FTX. “The worry is that if you make a big profit, you can’t take it out of the platform,” he says.

His concern seems justified. Ask Galois Capital, the company that profited from Terra’s collapse. He is now stuck with half his capital trapped on the bankrupt FTX platform.

This story was originally featured on Fortune.com

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